Advanced Issues Lecture 1 Flashcards
Financial reports should include all financial facts that would influence the judgment of an informed reader
Full Disclosure Principle
- Related Party Transactions
- Post-Balance-Sheet Events (Subsequent Events)
- Reporting for Diversified (Conglomerate) Companies
- Management’s Discussion and Analysis
- Forecasts and Projections
Disclosure Issues
Should all companies have the same reporting requirements?
* Some believe small companies should have less onerous
requirements
* Big GAAP vs. Little GAAP
* FASB has traditionally taken the positon that there should only
be one set of GAAP
Differential Disclosure
Transaction in which one of the parties has significant influence over
the other (or incentive to do the other a favor)
* e.g., car manufacturers and parts suppliers or buying a car from your
parents
Required Disclosures
* Nature of relationship
* Description of transaction
* Dollar amount for each period of income statement presented
* Dollar amount for accrued amounts as of each balance sheet date
presented
Related Party Transactions
Two kinds of subsequent events. Those that…
* …provide additional evidence about a conditions that existed at the
balance sheet date (recognized subsequent events).
* …provide evidence about conditions that did not exist at the balance
sheet date (non-recognized subsequent events).
Post-Balance-Sheet Events
…provide additional evidence about a conditions that existed at the balance sheet date
Recognized Subsequent Events
provide evidence about conditions that did not exist at the balance
sheet date
Non-Recognized Subsequent Events
Adjust the financial statements
* Disclose in the footnotes
* Information that the accountant would have recorded, had it been
known before the books were closed
Recognized Subsequent Events
Do not adjust the financial statements
* Maybe disclose in the footnotes
* Should disclose events when non-disclosure would cause the financial
statements to be misleading
* Disclosure not required for non-accounting events or items disclosed some other
way (e.g., press releases)
Non-Recognized Subsequent Events
For Non-Recognized Subsequent Events, which would be disclosed in the footnote? (Four Things)
- Sale of bond or stock
- Business combinations
- Losses due to natural disasters
- New significant commitments
For Non-Recognized Subsequent Events, which would NOT be disclosed in the footnote? (6 things)
- Legislation
- Product changes
- Management changes
- Strikes
- Unionization
- Loss of important customers
How does management split the company when making
decisions?
- Products and services
- Geography
- Legal entity
- Customer type
For diversified companies, we cannot assume all segments
perform equally well each year
* Disclosure should disaggregate results by operating segment
Management Approach
- Investors can better forecast future profits and cash flows
- Investors can better estimate the overall worth of a company
- Absence of segment disclosure puts non-diversified
companies at disadvantage (no where to hide all the things
management wanted retain the right to hide on previous
slide)
In other words, investors say,
“Please make management
disclose segments!”
Segment Disclosure - Pros
Investor needs to be knowledgeable about more industries to
avoid misinterpretation
2. “Enemies” (e.g., competitors) may use information against
company
3. Managers may avoid risks (even when they are worth it) for
fear of how loss will look when disaggregated
4. Accounting at segment level is not always meaningful
5. Investor should not care about segments if overall
performance is good
6. Preparing disclosures is hard
In other words, management
says, “Please don’t make us
disclose segments!”
Segment Disclosure - Cons
An operating segment is a component of the business that:
- Earns revenues and incurs expenses
- Has its results reviewed regularly by the chief operating decision-maker
(e.g., COO, CEO, etc.) - Generates distinct financial information
An Operating Segment can combine components that are the same across all below:
- Nature of products or services
- Nature of production process
- Type of customer
- Method of product/service distribution
- Regulatory environment
Segment is significant if it passes ONE OR MORE OF the
following tests:
- Revenue Test
- Profit or Loss Test
- Identifiable Assets Test
- AND sum of reported segments’ revenue ≥ 75%
- AND number of segments ≤ 10
18
General rule: report all materially significant segments
Determining Segments to Report
- Sum revenues of individual segments
- Report segments with revenues greater than 10% of (1)
Revenue Test
- Sum profits of all segments with profit
- Sum losses of all segments with loss
- Select larger of (1) or absolute value of (2)
- Report segments with profits greater than 10% of (3) or absolute value of
losses greater than (3)
Profit or Loss Test
- Sum identifiable assets of individual segments
- Report segments with identifiable assets greater than 10% of (1)
Identifiable Assets Test
Unaudited additional information from management
* Additional disclosures related to: liquidity, capital resources, results of operations
Management’s Discussion and Analysis
- Since SOX management must expressly state responsibility for
- Financial statements
- Controls over financial reporting
Management’s Responsibility for Financial Statements
set of future financial statements, given expected conditions
Financial Forecasts
protects company that makes an erroneous forecast as long as it was prepared on a reasonable basis
Safe-Harbor Rule
set of future financial statements,
given hypothetical conditions
Financial Projections
Think of the financial statements as a means of answering a
question about the company (Investors versus Creditors)
Investors: Would this company be a profitable investment?
* Creditors: If I loan money to this company will they be able to repay me?
When conducting a financial statement analysis Identify what information will help to answer your question
- Financial ratios
- Comparison of company to itself over time
- Comparison of company to competitors during same time period
Compare parts of the financial statements to each other to
better understand position of the company
Ratio Analysis
Four major types of ratios that we will cover:
- Liquidity
- Activity
- Profitability
- Coverage
- Ratios that measure the company’s short-term ability to pay its maturing obligations.
- Current ratio
- Can company pay loans due now with liquid assets?
- Quick ratio
- Can company pay loans due now with REALLY liquid assets?
- Current cash debt coverage
- Are company’s cash flows sufficient to pay loans due now
In other words: Can company pay the items that it HAS to be pay NOW.
Liquidity Ratios
Can company pay loans due now with liquid assets?
Current Ratio
Can company pay loans due now with REALLY liquid assets?
Quick Ratio
Are company’s cash flows sufficient to pay loans due now
Current Cash Debt Coverage
Ratios that measure how effectively the company is using its
assets
* Accounts receivable turnover
* How well does the company judge credit risk and manage collections?
* Inventory turnover
* How well does the company manage its inventory process?
* Asset turnover
* How well, in general, does the company convert its assets into revenue?
In other words: Ability to convert assets into financial benefits.
Activity Ratios
How well does the company judge credit risk and manage collections?
Accounts Receivable Turnover
How well does the company judge credit risk and manage collections?
Inventory Turnover
How well, in general, does the company convert its assets into revenue?
Asset turnover
Ratios that measure the degree of success or failure of the
company for a given period of time.
In other words: Did the company provide value for those who provided financing
and did the company use its investments wisely?
Profitability Ratios
Success generating value from operations:
Profit margin on sales
* Return on assets
Success generating value for shareholders:
- Return on common stock
- Earnings per share
- Payout ratio
- Ratios that measure the ability to repay long-term creditors and
investors. - Debt to assets ratio
- Times interest earned
- Cash debt coverage
- Book value per share
In other words: How likely is it that creditors and investors will get their money back?
Coverage Ratios
Does the company have sufficient assets to cover debt that could be seized in the event of default?
Debt to Assets Ratio
Will company be able to keep up with interest payments?
Times Interest Earned
Does company have sufficient cash flows to cover debt obligations?
Cash Debt Coverage
What is the return to a shareholder if company liquidates?
Book Value Per Share
Compare a company’s performance year-over-year
Horizontal Analysis
Each line item expressed as a percentage of another
* Particularly helpful when comparing companies of different sizes
Vertical Analysis (Common Size)
